A recent Legal & General (L&G) survey has looked at what it calls the “lottery effect” of receiving sudden wealth in the form of pension tax-free cash.

Receiving a large lump sum can trigger a desire to spend and a feeling that the money is a “bonus”. But more than half (58%) of those surveyed admitted to making retirement decisions without advice and 1 in 7 later regretted accessing pension funds. The main concerns of responders were around budgeting and the likelihood of running out of money.

As with all retirement decisions, the choice of whether or not to take tax-free cash is an important one and the consequences of getting it wrong can be far-reaching.

With that in mind, keep reading for your guide to pension tax-free cash and why advice is so important at this crucial time.

25% tax-free cash is usually available on retirement, but you can decide how, when, and if you take it

For the defined contribution (DC) pensions you hold – sometimes referred to as “money purchase” schemes – you can usually take up to 25% of your pension pot as tax-free cash at retirement.

This is generally the case whichever option you choose, and you have three main choices:

An Annuity

An annuity is the “traditional” retirement option and uses your pension pot to purchase a guaranteed income for the rest of your life. You choose the payment frequency and any additional benefits, such as a spouse’s pension, and receive your pension as a stable income.

You also have the option to take 25% of your fund as a pension commencement lump sum (PCLS).

As with the additional benefits you might choose, taking a tax-free cash lump sum will lower your regular income but it might be a good choice if you have big-ticket purchases planned, or one-off expenses like travel.

Uncrystallised funds pension lump sum (UFPLS)

You might opt to take your entire pot as a lump sum (or a series of lump sums). You’ll receive the first 25% of each payment tax-free, with the rest taxed as income at the highest rate of Income Tax you pay.

This option allows for flexibility but places the onus for responsible budgeting on you. Before taking an UFPLS, be sure you know how the whole of your retirement will be paid for, and plan accordingly so you don’t run out of money.

Flexi-access drawdown

This flexible approach allows you to draw down income as and when you need it, while the rest of your pot remains invested.

Your expenditure in retirement is unlikely to be uniform so a flexible approach could allow you to cover these fluctuating costs.

Again, though, you’ll need to keep an eye on your budgeting and ensure your remaining pot will cover you for the rest of your retirement.

There are pros and cons to taking tax-free cash, so you’ll need to think carefully before you decide

L&G’s survey found that many retirees experienced the payment of tax-free cash like a lottery win, with:

• 15% seeing tax-free cash as an unexpected financial bonus, rather than part of their long-term plans
• 10% confirming that the receipt of tax-free cash felt like payday
• 46% of those surveyed admitting that they accessed the cash simply because they could.

Advice is key here because you must understand why you’re taking tax-free cash before you choose to receive it and think carefully about the alternatives.

Benefits of taking tax-free cash

As we have seen, tax-free can be accessed flexibly and you can decide how much you take (up to the usual maximum of 25%).

If you have plans for the early, active years of your retirement, access to cash could be crucial. You might have large one-off purchases you intend to make, for house renovations, say. Or maybe you have plans for world travel.

Tax-free cash can make these dreams a reality, but large purchases should already be a part of your long-term financial plan. This ensures that they’re included in your budgeting, and you’ll be safe in the knowledge that you can afford the expenditure.

Some negatives to taking tax-free cash

Large lump sums can deplete your fund more quickly than you realise so it’s important to think of these withdrawals within the context of your long-term plans.

Even though the cash itself is tax-free, there could still be tax implications, so you’ll need to think these through. Tax-free cash payments might be subject to emergency tax or even move you into a higher tax bracket.

It’s also important only to withdraw the tax-free cash you need. Taking too much means that your money could end up sitting in a low-interest high-street bank account, say, where its purchasing power might be diminished by inflation.

There’s also the opportunity cost to consider. Money taken as tax-free cash is no longer invested, and you won’t receive a return on it. Be sure the money you take is earmarked and spent, and consider leaving the rest invested.

Advice is crucial so get in touch if you need help

As with all at-retirement choices, the decision of whether to take tax-free cash is an important one with far-reaching consequences.

For that reason, it’s vital that you don’t become one of the 14% who take tax-free cash and later regret it. Or the 58% who accessed their fund without first seeking advice.

If you need help deciding if an annuity is right for you, get in touch. Email info@thepensionplanner.co.uk or call 0800 0787 182.

Please note:

This article is for general information only and does not constitute advice. The information is aimed at retail clients only.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance. The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.

Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation, and regulation, which are subject to change in the future.